Many of us have prepared or reviewed financial projections. Most projections are usually based on a per-unit sales estimate, long-term contract analysis or some sort of extrapolation of historical growth trends. Some projections are spot on every year, but other projections are littered with illogical conclusions and calculation errors.
While any set of financial projections is dependent upon numerous assumptions, there are a few critical areas that are more prone to errors than others.
The first critical area pertains to revenues. We regularly notice that revenues are projected to increase beyond the company’s current capacity to support those revenues. Such projections need to consider the necessary investment in capacity for things such as building space, equipment and human capital. Much of the capacity issue can be solved by projecting appropriate investments in fixed assets and working capital. Therefore, projecting balance sheets in conjunction with income statements will aid in the determination of setting appropriate capacity levels.
There are also other common errors of omission, such as failure to consider economic or statutory changes impacting an industry. It is not uncommon to see projections that use historical interest rates to project payments on variable interest rate debt, when some consideration of current market rates should be used. Other times, specific industry changes such as new taxes, significant changes to commodity costs or incorporating a conversion cost to comply with regulatory requirements are ignored in corporate projections. These items, which may be somewhat difficult to determine at times, still need to be factored into projections in order to accurately reflect the company’s expected future operations.
Finally, as alluded to above, many projections deviate significantly from historical behavior. This is acceptable if supported with conclusive evidence such as historical growth trends or industry growth expectations. More often, however, these departures are not supported with sufficient cause for changing from historical norms. For example, analyzing historical costs to determine what caused those costs to fluctuate is important in establishing projections. There are a number of methods to analyze cost behavior, with some common considerations being: evaluating payroll in relation to sales, bonuses in relation to profitability, repairs in relation to fixed assets, supplies in relation to production and travel expense in relation to geographical reach. The point here is that projections may call for deviations from historical cost behavior and subscribe to different cost expectations that may have little chance of being met. Looking at history does not allow you to predict the future, but if often provides the best basis for establishing reasonable projections.
Nobody knows what is going to happen in the future, which makes developing financial projections a difficult task. Keeping these few common errors in mind, however, will hopefully offer some guidance when preparing projections to give you the highest likelihood of accurately predicting the future.
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